Barclays VIX Note Vexes Investors Not Savvy on Volatility

By Matt Robinson and Margaret Collins -
May 2, 2012

Ian Mathers reckoned stocks were due
for a slide as the Standard & Poor’s 500 Index approached a
three-year high in February.

So the 34-year-old Medevac pilot and day trader bought an
exchange-traded note from Barclays Plc (BARC) that’s designed to profit
when stock prices get more volatile. Mathers didn’t realize the
note tracks a different volatility index from the widely
followed S&P 500 VIX benchmark, and could produce much different
results. The confusion cost him 6 percent of his investment over
two days.

The Barclays note, called the iPath S&P 500 VIX Short-Term
Futures ETN, is among a slew of new products allowing individual
investors to make the kind of sophisticated bets on price swings
that were only available to institutional buyers as recently as
three years ago. The security is poorly suited for a buy-and-hold strategy, having plunged 96 percent since inception.
Mathers noticed that even when the VIX was unchanged, he lost
money.

“I got burned,” Mathers said in a telephone interview.
“You wouldn’t get what you think you’d pay for. It’s a
dangerous product.”

Banks such as Barclays and UBS AG (UBSN) are pitching ETNs tied to
volatility as a way for investors to bet on spikes or declines
in the stock market and to protect against losses. About 30
volatility products have been listed since January 2009. The
Barclays note was first and has $1.8 billion in assets, making
it the largest tied to volatility.

‘Not a Stock’

Many investors don’t understand that investments linked to
volatility don’t react in the same way as traditional products,
said Jim Strugger, a derivatives strategist for MKM Partners LLC
in Stamford, Connecticut.

“It’s not a stock. That’s inherently the problem,”
Strugger said in a telephone interview, as too many investors
oversimplify the gauge. “When bad things happen, volatility
goes higher.”

The U.S. Securities and Exchange Commission is probing
price gyrations in a Credit Suisse Group AG (CSGN) volatility ETN that
lost half of its value in two days, a person familiar with the
matter said in March.

Regulators Crack Down

Regulators have already cracked down on leveraged or
inverse ETFs that Wall Street markets and sells to retail
customers. The Royal Bank of Canada said today it agreed to
reimburse Massachusetts investors as much as $2.9 million and
pay a $250,000 fine over sales of those types of ETFs.

The Financial Industry Regulatory Authority, the industry-backed regulator, also fined banks including Wells Fargo & Co. (WFC),
Citigroup Inc. (C), Morgan Stanley (MS), and UBS about $7.3 million
yesterday to settle claims they failed to properly supervise
sales of similar ETFs. The firms also didn’t have a reasonable
basis for recommending the securities to their clients, Finra
said.

Exchange-traded notes are contracts between investors and
banks that are less regulated than mutual funds and can be more
complex than exchange-traded funds. ETNs are backed only by
their issuer’s credit, unlike ETFs and mutual funds, which hold
assets. The notes are about a $17 billion market, a fraction of
the $1.2 trillion in ETFs.

Loss Protection

Investors use volatility products to protect against sudden
losses in the S&P 500. The VIX has moved in the opposite
direction of the S&P 500 about 80 percent of the time, data
compiled by Bloomberg show. Buyers earned 14.8 percent on the
Barclays note the Monday after the U.S. was stripped of its top
credit rating last August, while the S&P 500 lost 6.7 percent.

Mathers bought the Barclays note expecting it to move in
lock-step with spot VIX, as the Chicago Board Options Exchange
Volatility Index is known. Instead, the note tracks futures
contracts, which means it won’t necessarily match the
performance of that gauge.

Shares outstanding for the Barclays note hit a record 114
million on March 23 even as the security had lost more than 51
percent of its value this year as of that date.

Mathers, the pilot, bought 75 shares of the Barclays ETN on
Feb. 21 when volatility closed higher at 2.31 percent, except
the note fell 0.13 percent. It dropped an additional 2.82
percent the following day, while the VIX was unchanged. Since
the notes are tied to futures, they can lose their value because
of a market phenomenon known as contango, when later contracts
cost more than earlier ones.

’Roll Yields’

That issue isn’t disclosed until page 15 of the note’s
prospectus: “The existence of contango in the futures markets
could result in negative ‘roll yields’, which could adversely
affect the value of the index underlying your ETNs and,
accordingly, decrease the payment you receive at maturity or
upon redemption.”

Kristin Friel, a spokeswoman for London-based Barclays,
declined to comment.

ETFs betting on volatility also have declined because of
contango. The ProShares VIX Short-Term Futures ETF, which tracks
a similar index as the Barclays note, has fallen 57 percent
since inception in January 2011.

Inexperienced traders looking to make a “quick buck” are
behind some of the demand for volatility notes, said Bill Luby,
founder of the VIX and More blog who has traded the securities.
These investors “are probably not sophisticated enough to buy
options,” Luby said in a telephone interview, so they buy notes
tied to volatility. Options are contracts that give the
purchaser the right, but not the obligation, to buy or sell a
security.

No Portfolio

When investors buy ETNs, they loan money to banks, which
promises to pay them the performance of an index, minus fees. If
the issuer goes out of business, investors must stand in line
with other creditors to try to recoup their money. That’s what
happened to investors in ETNs issued by Lehman Brothers Holdings
Inc., when the firm declared bankruptcy in September 2008.

“Banks can invest that money any way they want to,” said
Colby Wright, assistant professor of finance at Central Michigan
University. “Some investors would be surprised to know that
there is no portfolio underlying the returns that are being
generated.”

Very Sophisticated

“These are products that are developed by very
sophisticated folks in the industry and I wonder to what degree
they are developed with the retail investor in mind,” said Matt
Kitzi, securities commissioner of Missouri.

Because of their structure, ETNs can be created on
anything, said Kyle Schaffer, senior investment adviser at
Ballentine Partners LLC in Waltham, Massachusetts. “I could in
theory sell you an ETN that promises to go up by 1 percent for
every run the Red Sox score.”

That’s an advantage of ETNs, Schaffer said. There aren’t
too many ways to get volatility exposure, for example, which is
why investors may look to the notes, he said. They’re also tax
efficient. Investors generally don’t get taxed until they sell
and profits are taxed at capital gains rates, which usually are
lower than rates on income. Schaffer’s firm invests in a
Barclays commodity ETN for clients, who have at least $20
million in net-worth.

Opaque Fees

It’s often hard for investors who aren’t very comfortable
digging through prospectuses to figure how much they’re paying
for the notes, said Morningstar’s Lee.

“The fees in these exchange-traded notes can be very
opaquely disclosed, buried under mounds of math,” he said.

The average ETN annual investor fee is 0.84 percent,
according to Morningstar data. That doesn’t include a lot of the
tacked-on charges, Lee said. The UBS short VIX ETNs, for
example, add about a 4 percent annual fee for “event-risk”
hedging, leading to a total cost of 5.35 percent, he said.

Christiaan Brakman, a UBS spokesman, declined to comment.

The complexity of ETNs hasn’t scared away buyers. Investors
looking to protect against declines in the S&P 500 created so
much demand for an ETN tied to equity volatility that Credit
Suisse stopped issuing shares on Feb. 21.

That resulted in an 89 percent premium in the note’s price
on March 21 over the index it tracked. The note lost more than
50 percent of its value in two days.

Mathers, the pilot who bought the VIX note, said he won’t
invest in volatility products again and thinks buyers should be
warned before investing.